Regulators Further Define “Swap” and Finalize End-User Clearing Exception
In a joint rulemaking effort this month, the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC,” the SEC and CFTC collectively referred to as the “Commissions”) voted to finalize two major rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). The first rule approved key definitions of certain derivatives products, such as “swap.” As part of the rulemaking, the CFTC clarified that certain volumetric optionality contracts and book-outs will be forward contracts, and, thus, not a swap under the Dodd-Frank Act. Once published in the Federal Register, the rule will trigger the countdown for certain compliance, reporting and registration requirements for swap market participants. The second rule provides which entities may elect not to submit certain swaps for clearing to a derivatives clearing organization, including end-users and certain small financial entities.
Swap Products Definitions and Interpretations
The Commissions finalized the rules and interpretations (i) further defining “swap,” “security-based swap,” and “security-based swap agreement,” (ii) providing for the regulation of “mixed swaps” and (iii) adopting specified books and records rules for security-based swap agreements (the “Final Products Rule”). Swaps are regulated by the CFTC and security-based swaps are regulated by the SEC, but mixed swaps may be regulated by either or both the SEC and the CFTC depending on the nature of the product. Security-based swap agreements, as opposed to a security-based swap, are a type of swap related to securities over which the CFTC has full regulatory and enforcement authority under the Dodd-Frank Act, and over which the SEC also has certain enforcement authority and access to information from certain CFTC regulated entities.
The term “swap” is broadly defined under the Dodd-Frank Act and includes, for example, interest rate swaps, commodity swaps, currency swaps, equity swaps and credit default swaps. The Commissions’ rules and interpretations seek to further clarify which transactions will be treated as swaps. The Commissions clarified that the term “swap” includes foreign exchange swaps and forwards (subject to Treasury Department determinations), foreign currency options, commodity options, non-deliverable forwards in foreign exchange, cross-currency swaps, forward rate agreements, contracts for differences, options to enter into swaps and forward swaps.
As a response to commenters in the energy industry, the Commissions also provided guidance regarding forward contracts with embedded volumetric optionality. Natural gas and electricity suppliers frequently enter into commercial transactions with embedded optionality as to the volume of energy that is physically delivered in order to meet varying customer demands. The embedded volumetric optionality exclusion provides a seven-part test requiring, among other things, that the volumetric optionality be due to physical factors or regulatory requirements beyond the control of the parties. Forward contracts meeting the requirements of such test will be treated as forward contracts rather than swaps under the Dodd-Frank Act.
The CFTC is providing a sixty day public comment period after the Final Products Rule is published in the Federal Register on the embedded volumetric optionality exclusion and the CFTC’s interpretation thereof.
The Final Products Definition also seeks to clarify the treatment of certain transactions in non-financial commodities. For example, “booked-out” transactions in nonfinancial commodities entered into by commercial participants in connection with their business which meet the requirements specified in the CFTC’s “Brent Interpretation” regarding forward contracts, and which are effectuated through a subsequent, separately-negotiated agreement, would qualify for the forward exclusion under the swap and future delivery definitions. Oral book-outs may be permissible if they are followed in a commercially reasonable time frame by a confirmation in some type of written or electronic form.
The Final Products Rule also discusses the treatment of environmental commodities such as offsets, allowances and renewable energy credits, but the rule does not address the treatment of regional transmission organizations’ and independent system operators’ products or other products regulated by the Federal Energy Regulatory Commission, which also may be subject to CFTC jurisdiction. Instead, the CFTC intends to handle the treatment of such products through its public waiver process pursuant to its “4(c) exemption” powers that allows the CFTC to exempt transactions and products from certain CFTC rules and regulations if the CFTC finds such an exemption would be in the public interest.
End-User and Small Financial Institution Clearing Exception
Generally, the Dodd-Frank Act requires that a swap must be submitted for clearing to a derivatives clearing organization. However, the Dodd-Frank Act provides an elective exception (often referred to as the end-user clearing exception) where one party to the swap may elect not to clear the swap transaction. Under the Dodd-Frank Act, for the exception to be available one of the counterparties to the swap must: (i) not be a “financial entity” as defined in the Dodd-Frank Act, (ii) be using the swap to hedge or mitigate commercial risk, and (iii) notify the CFTC, in a manner set forth by the CFTC, as to how it generally meets its financial obligations associated with entering into non-cleared swaps. This reporting can be done either on a swap-by-swap basis or an annual basis.
When electing not to clear a swap, if the electing party issues securities or files reports under the Securities Exchange Act of 1934, such party must notify the CFTC whether a committee of the board of the electing party has approved the decision to enter into non-cleared swaps. The final rules clarify that this board approval requirement can be satisfied by general approval with respect to the electing party’s swap business rather than on a swap-by-swap basis. The CFTC further clarified that “[t]he Commission would expect an [electing party’s] board to set appropriate policies governing the [electing party’s] use of swaps subject to the end-user exception and to review those policies at least annually and, as appropriate, more often upon a triggering event (e.g., a new hedging strategy is to be implemented that was not contemplated in the original board approval).”
The CFTC has stated that in regard to the determination as to whether a swap is being used to hedge or mitigate commercial risk the “criteria set out in the rule are virtually the same as the criteria used in the definition of ‘major swap participant’ recently adopted.”
To allow certain small financial institutions to elect the end-user clearing exception, the CFTC also finalized an exemption for certain financial entities from the definition of “financial entity” used in the end-user clearing exception with total assets of $10 billion or less.
The Final Products Rule sets in motion an implementation chain reaction such that nearly a dozen rules will go into effect sixty days after the Final Products Rule is published in the Federal Register, including rules relating to: the registration of swap dealers and major swap participants; internal and external business conduct standards; real-time reporting requirements; regulatory reporting and recordkeeping obligations under part 45 of the CFTC’s Regulations; historical swap data reporting; and all spot-month limits and non-spot-month legacy limits.